China project bond potential

EmilyChurch

NEW YORK (CBS.MW) -- Over the past few weeks, China?s leadership has unveiled an economic reform path that is nothing short of revolutionary.

Newly anointed Prime Minister Zhu Rongji on Thursday promised to tackle insolvency at state-owned industries and overhaul the country?s banking system. He also told reporters in Beijing that the state bureaucracy would be cut by half.

"This is bold thinking, not just fixing around the margins but a serious attempt to address the problems," said Robert Radtke, assistant director for U.S.-Northeast Asia Programs at the New York-based Asia Society. "Zhu has put his stamp on this as leader and his career is really staked to this." "This is bold thinking, not just fixing around the margins but a serious attempt to address the problems."

Robert Radtke Asia Society Few details have emerged, but analysts don?t doubt that China needs to raise a lot of capital to overhaul its moribund state-owned enterprises and launch a 3-year, $1 trillion infrastructure spending plan that some call China?s "New Deal." The question for U.S. investors is where will China turn for financing.

Minnow market

To date, only $17 billion outstanding has been raised by bond financing by mainland Chinese companies or state-backed enterprises for infrastructure projects, says Moody?s Investors Service, a bond rating agency. China appears to be raising most of its capital internally.

Moreover, secondary trading in Chinese enterprise bonds is too thin to attract much attention from fund portfolio managers. Yet, some analysts are expecting that to change.

"I think they will have to come to economies like the U.S. and I would take it seriously," Radtke said. "The stakes are too high for them not to fail in a way. If they fail, the entire political structure in China will come into question. The leadership needs to make this succeed using whatever powers they have."

Exports threatened

China raised the amount of money it expects to spend on public works by $300 billion in recent weeks to reach the $1 trillion mark.

"We think it?s rather vague," said Moody?s analyst Stephen Hess, who calls the trillion dollar capital spending plan rhetorical. "Nothing is definite yet in terms of a plan. If a trillion dollars is the total spending over the period on infrastructure, then yes it is an increase, but not as huge as it sounds."

China has been spending heavily on its infrastructure. What?s changed is the export picture.

For the time being, China has been running a current account surplus on its balance of payments, which has not compelled the country to seek capital aggressively, analysts say. Yet China is now facing greater competition in the export market from its Asian neighbors armed with newly devalued currencies.

The loss of precious export dollars comes at a time of rising unemployment in China.

"This is unclear now, but this is real. Without enough infrastructure expenditure, they just can?t have enough growth in the economy for this year and next year when they are firing so many people," said Henry Ho, the Hong Kong-based portfolio manager of the Greater China Fund (GCH)
GCH, -0.11%
with $245 million in net assets.

"My belief is that they will have to make use of two things: One is foreign capital, and at the moment most of the foreign capital that they are trying to get is still the foreign direct investment and also through the equity market. The second route is definitely the domestic savings."

In general, the bond market for Chinese issuers is only a few years old. The complicated holding structures "make the bonds and the analysis of the risk complex. That is one reason why we would expect that after all of this infrastructure spending is realized, it may not be a huge boom."

Stephen Hess Despite China?s size and potential, there aren?t many choices out there for U.S. bond investors to get into the country. China?s currency is not fully convertible, that alone has helped keep even the larger players on sidelines. J.P. Morgan, for example, invests in short-term China debt issues through an off-shore strategy tracked by its Emerging Local Markets Index.

"If you don?t go for direct investment projects then its the equity market. Debts are not very attractive as far as I can see because the yields are not that high," said Ho.

China isn't likely to face many difficulties floating bonds to finance big infrastructure projects like the massive Three Gorges dam, but China may face resistance on the smaller projects, Ho said.

However, China has "been increasing these bond financings for infrastructure projects like electrical power plants and highways," Hess said. "We rated a number of bonds in these areas."

Rating complexities

Because Chinese law prevents the provinces from raising capital directly in the foreign markets, the regional government entities create complicated holding structures to issue debt for project financing. Ratings therefore suffer because of the higher risks involved for investors.

In lieu of a standard guarantee for the debt repayments, for example, a province building an electrical plant will promise to purchase power from the plant for the next 10 years.

The complicated holding structures "make the bonds and the analysis of the risk complex," said Hess. "That is one reason why we would expect that after all of this infrastructure spending is realized, it may not be a huge boom."

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